Tuesday, 24 February 2009

Paying in the last resort

It is clear by now that the lender of last resort function - and especially the capital provider of last resort function - is valuable. How should the state be paid for this function?

The historical answer has been that this is a gift to the banking system, with the state attempting to recoup its investment (and perhaps even make some money) from the liquidity and capital that it provides. At the moment however it seems likely that some of these state investments will not give taxpayers a positive return, so it is reasonable to ask how else we could structure things.

One answer is that financial institutions should pay. The model here is deposit insurance: in the US, for instance, banks are charged by the FDIC, and these premiums are pooled together to support bank rescues where necessary. However it seems that these payments are not adequate, and so deposit insurance premiums are being increased - just at the worst possible time. It is easy to argue that they should have been higher in the past. In practice however banks' success at promoting deregulation and cost reduction in the good times means that fixed fee schemes are always vulnerable.

There is an alternative. Banks could be made to pay by writing call options on their own stock. Suppose every year a bank gives to their regulator, as payment for the lender of last resort and capital provider of last resort functions, one year at the money call options on 5% of their regulatory capital. The regulator then hedges these to lock in their value. The hedge is to short stock, so if the option ends up in the money, the regulator ends up selling the stock position. The profit from delta hedging these 'free' options is then available to recapitalise banks when needed, and so the taxpayer does not lose out (as much) when support is needed. The people who suffer are bank shareholders, but they only suffer dilution when the stock price is increasing, and anyway they are the ones who should be paying for the implicit support the state provides.

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